Should We Be Worried About the VIX Implosion?

Don't short the market on the CBOE Volatility Index (VIX) dip

Mar 3, 2015 at 8:44 AM
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Happy Nazz 5,000, everybody. Do I hear 6,000? 8,000? 10,000?

The TV spent most of the day discussing whether we were in a bubble. The consensus was basically "no." That's not to say we actually kept lifting, just that it's not 2000 again (the year, not the Nasdaq price). I would agree on the non-bubble part, though I find bubble discussions pretty much useless. Is there really some sort of official bubble designation? Does it add any value to an investor? Everyone pretty much knew we sat in a frothy environment in 1999-2000. But it wasn't all that easy to go short anything and time it well enough to actually make money when we finally dropped. I wouldn't just go short now, or ever, because of price or some value metric. Overpriced can become very overpriced before it turns. I'd rather miss the top.

Anyway, we're more of a CBOE Volatility Index (VIX) operation here anyways. And as noted the other day, VIX just came off its worst month ever in percentage terms. It closed February down 36.39%. And even with that, VIX isn't cheap relative to realized volatility.

So, does this VIX dip mean much for the market? Here is the top 25 monthly VIX dips of the past decade:

Top 25 Monthly VIX drops vs. Top 25 Monthly SPY drops

The Start Date is the last trading date of the month preceding the VIX dip. The Starting VIX is the VIX close on that date. VIX Next Month is … well, I hope self-explanatory. And SPY Next Month is how SPDR S&P 500 ETF Trust (SPY) did in the following calendar month, hence the '???' in the top line, as we have to wait until the end of March to find out.

So, should this VIX implosion worry us? Not really. As you can see, SPY performance going forward runs all across the gamut. Throw all 120 cycles over the last decade together and we find the monthly VIX move has a negative-17 correlation to the SPY move the next month. Thus, it's a moderately positive tell going forward.

But I suspect it's less "signal" and more "train in motion staying modestly in motion." If the VIX is doing that poorly, it probably means the market is rallying and worries are decreasing that the rally will continue. That's often complacency, and complacency is very tricky to time on a contrary basis.

The best contra-tell in this sample was in December 2008. VIX dropped 27.64% for the month, then SPY dipped 8.21% in January. It's very important to note that the market was a disaster zone at the time, and VIX was 55 at the start of the whole cycle, so it was only complacency relative to the panic before that.

Long story short -- don't go shorting the market based off this swift VIX drift. It might work, but there's no suggestion that VIX is "calling" it.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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